Currency manager calls for Swiss franc liquidity inquest

The collapse of foreign exchange liquidity during and after the huge Swiss franc move on January 15 caught market participants by surprise. Some are calling for an official enquiry

Surprise shift: many dealers were forced to make some tough choices

On January 15, currency markets experienced one of their largest intra-day moves in decades. Following the Swiss National Bank's surprise decision to abandon its currency floor, the Swiss franc soared 40% against the euro and 25% against the dollar in a matter of 30 minutes, from 9:30am UK time, before giving back most of its gains.

When the dust settled, market participants were able to assess the damage: three major foreign exchange dealers – Barclays, Citi and Deutsche Bank – were sitting on combined losses of more than $400 million; hedge funds Comac Capital in London and Everest Capital in Florida were returning capital to investors after suffering losses exceeding $1 billion; and the largest US retail forex brokerage, FXCM, was teetering on the brink of collapse.

But some of the damage was hidden. Buy-side firms complain some banks shut up shop in the minutes following the SNB's decision, and say it took days for liquidity to fully return. The question is whether this was due to design flaws in the modern, largely electronic currency market or constrained risk appetite as dealers licked their wounds. Some are now calling for an official post-mortem.

The episode "merits a proper review" by market watchdogs, says James Wood-Collins, chief executive of Record Currency Management in Berkshire, which manages $53 billion in currency exposures for institutional investors. "The banks may well have done their best in the circumstances with the risk budgets and capital available to them, but as market participants, we do have to face the fact that the market was not there – in terms of the size and liquidity and spreads we would expect – for a surprisingly long time," he says.

Counterparty concerns

The chief risk officer of a large US hedge fund in Connecticut tells a similar story. "The market was not cool and calm. As spreads went up, we didn't know who was in the market and who wasn't. There were severe counterparty concerns in the first 30 minutes and disputes over what were or weren't off-market trades, especially with electronic trading," he says.

Currency dealers and forex platforms, however, are defending their performance. "A currency moved over 30% on a true and surprise shift in monetary policy, and we didn't see massive trade breaks or settlement fails. There was no systemic risk or major dislocation in the economy or for end-users. I would say the currency markets performed extraordinarily well, with 99%-plus electronic trading efficiency," says Chris Bae, head of global fixed income, currencies and commodities (Ficc) electronic trading at Bank of America Merrill Lynch (BAML) in New York.

Executives at other sell-side firms concur. The head of Ficc trading at a European bank in New York says the currency market was "quite resilient" on January 15, while the global head of e-commerce sales at another European bank in London calls it a "blip".

Buy-side sources say the performance of forex liquidity providers and their experience as customers differed markedly from one dealer to the next. "The banks that were more consistent and constructive in providing liquidity in this crisis were not necessarily the ones we would have expected," says the head of a big UK-based asset management firm.

Liquidity provision in currency markets is largely reliant on electronic market-making systems and algorithms, with around two-thirds of global forex volume executed electronically, according to Greenwich Associates.

If people don't know what is happening, there is no reason to believe an algo does

Regulators have encouraged this, especially in light of allegations that forex traders rigged currency rates. Last year, Switzerland's markets regulator, Eidgenössische Finanzmarktaufsicht, ordered UBS to automate at least 95% of its foreign exchange trading after it was fined for market manipulation. 

Put crudely, forex algorithms make prices by matching or internalising opposing client interests and then factoring in the cost of covering the residual risk in the interdealer markets. The biggest dealers effectively operate internal exchanges, consolidating currency trading within single global dealing books where client orders are matched off against one another. Firms with diversified books internalise as much as 90% of their flow, and the quotes streamed to customers essentially reflect the cost of covering the residual risk in the interdealer markets.

This approach works extremely well when markets are stable and functioning normally. As a consequence, over the past decade, standard spreads in euros have fallen in the interdealer market from one pip – or one hundredth of a cent – to a fifth of that for some customers.

"The banks are manufacturing their own liquidity. That has allowed them to get customer spreads well inside the interdealer market spreads," says Simon Wilson-Taylor, president and chief executive of Molten Markets in Connecticut, which operates a forex trading platform and provides currency trading systems for the buy side. He was formerly head of Ficc e-commerce at UBS.

But the benefits of internalisation are limited in one-way markets, where every customer is scrambling for the exit and dealers are left to make markets based on rapidly changing reference prices in the interdealer markets.

Dealers were forced to make tough choices on the morning of January 15 and their responses spanned the gamut. "There was a real split camp across the Street as far as the Swiss franc move was concerned," says the New York-based head of Ficc at a large European firm.

Citi and Deutsche, for instance, offered continuous electronic pricing and execution through the worst of the Swiss franc move on January 15, according to several market sources, and ended the day with significant trading losses.

Other firms took the precautionary measure of dramatically widening spreads, switching off electronic pricing and execution engines, or automatically rejecting trades when customers sought to execute on resting prices.

"My understanding is some dealer systems had built-in circuit breakers that effectively said, ‘We don't know what's happening, we can't price this, so we're either not going to price or we're going to reject the trades we do price until we see the system settling down'," says Wilson-Taylor at Molten Markets. 

Case study

The actions of Switzerland's largest banks, Credit Suisse and UBS, provide a miniature case study.

Credit Suisse offered continuous electronic pricing and execution during the initial move – executing thousands of trades during those few minutes – and throughout the rest of the day, according to several market sources. The firm is said to have accrued trading losses as the market was crashing, but made money on offsetting positions in its derivatives books and elsewhere. Credit Suisse failed to respond to a request for comment by press time.

UBS, meanwhile, was more cautious. The bank switched to indicative pricing for 10 of the 30 minutes immediately following the removal of the currency floor, according to several sources, meaning trades entered into during this period had to be manually confirmed by the bank. UBS continued making manual prices via its voice desk during this time.

Kevin Arnold, head of foreign exchange, rates and credit for the Americas at UBS in New York, says the bank made the right call. "Markets break down because everyone pulls away at the same time. If people don't know what is happening, there is no reason to believe an algo does," he says.

UBS operated as normal after those first 10 minutes and during the rest of the day.

The shift to manual trading was apparent on EBS, an electronic spot currency trading venue for liquidity providers, operated by Icap, which serves as the primary reference price and trading platform for Swiss franc trades. The amount of manual trading on EBS jumped to 37% during those crucial 30 minutes, compared with an average of 30% over the previous three years.

"For a period of half an hour, manual trading became very important to the ecology," says Darryl Hooker, head of EBS Market in London. "The algo traders and price streamers declined the invitation to a certain degree, and manual traders took over those positions."

Despite this, EBS showed live prices – including two-way prices for 57% of the time during the first 15 minutes and 96% of the time in the second 15 minutes, and continuously afterwards, says Hooker. EBS operated as normal throughout January 15, he adds.

Electronic liquidity on dealer-to-client and all-to-all platforms was patchier.

"The electronic forex market was fairly unreliable that day. From a spread standpoint, you didn't know what you were going to get. So we went to the old-fashioned model and picked up the phone," says Mike Harris, president of Campbell & Company, a predominantly automated hedge fund in Maryland with around $5 billion in assets.

The company executed around 80% of its currency trades via voice on January 15, according to Harris. "We were testing the market by passing some orders through electronically, but as a result of the inconsistency of what we were getting back, we did most of our trades on the phone," he says.

Record Currency Management employs a team of five traders, and 40–60% of its trading is carried out over the phone. This approach paid dividends on January 15.

"A lot of people say trading can all go to an algo. But one of the reasons we do around half of our volume on the phone is to maintain relationships with an admittedly smaller and smaller number of traders on the dealing desks at banks," says Wood-Collins.

"The value of that is the transparency we get in these situations. When we're in an unusual market situation, having enough people on our side to call up dealers with which we have given business in the past and say, ‘Can you make me a price in this size?', and getting that call answered, can make all the difference," he adds.

Voice-trading benefit

For many buy-side firms, the experience highlighted the importance of maintaining voice-trading capabilities even as markets become increasingly electronic.

"In this electronic age, we get fooled into thinking we can trade any time we want on very tight spreads. These events are reminders there will be instances when that goes away and you need a contingency plan to deal with that," says Harris at Campbell & Company.

BAML's Bae believes that is the correct approach: "Electronic trading is not a panacea, especially when market structure is evolving so rapidly under regulatory influence. We don't view it as a panacea; we view it as a partnership – another tool to grab liquidity when you need it."

In volatile markets, size considerations may favour voice trading over electronic execution.

"If a client wanted to move €30 million of Swiss, on 99% of days, that's a fully electronic transaction, but in a highly volatile market that behaves much larger in terms of risk quantity. It's important to work with liquidity providers and ensure they understand your needs. Picking up the phone and having conversations is always good practice. We always encourage that with our client base," says Bae.

The buy side's concerns go beyond the disruption to electronic liquidity in the immediate aftermath of the SNB's announcement. The more "troubling" fact, says Record's Wood-Collins, is the length of time it took for the market to return to normality.

"There was at least an hour or so from 9:30am UK time when there wasn't an institutional-size Swiss franc market. That's understandable. But what we found more troubling is the market remained disrupted for a disappointingly long period afterwards. The institutional-size Swiss franc spot and outright forward market continued to be very fragile and illiquid through the Thursday and Friday, and into the following Monday and even on Tuesday," he says.

Record Currency Management trades in tickets of anything from $5 million to $20 million at a time in the normal course of business. "That would be perfectly ordinary," says Wood-Collins. But, through much of the period between January 15 and January 20, the firm was "struggling to do Swiss franc tickets of more than $1 million or $2 million without risking pushing the market away from us", he says.

On those days, some dealers were asking Record's traders where they thought the forward market was, says Wood-Collins – upending the traditional order of things. This uncertainty was reflected in pricing. Dealer quotes, which ordinarily overlap to a great degree, with the mid-points very close, were poles apart during those four days. "The bids and offers were not overlapping at all on a surprising number of occasions. The mid-points were more distant than the spreads," he says.

Human factor

The enduring fragility of the market had more to do with the business and profit-and-loss concerns of dealers – and the risk and capital constraints they face – than the vagaries of market-making algorithms.

"It was a straight business decision," says Arnold at UBS, which claims to have been very active in the market in the hours and days following the initial move. "We are the largest Swiss bank and there was an outsize day in this key currency. It was a day for us to stand up and be counted. We will be judged for years to come on how we acted that day."

Some dealers were motivated by different incentives and constraints. The removal of the exchange rate floor caught most dealers by surprise and some were positioned the wrong way.

Several dealers had sold put options on the US dollar/Swiss franc rate, for instance. As spot hurtled past the put strikes, dealers were forced to hedge their gamma exposure by selling into the move, driving the rate even lower. Some firms were left with significant losses, and spent the next few days paring positions and minimising risk levels rather than focusing on providing liquidity to clients.

"If you were betting against what happened and the alarm bells are going off, your first order of business was to minimise internal risk. Dealing with client flow wasn't the priority," says the head of Ficc at a European bank in New York.

In many ways, the Swiss franc move on January 15 is reminiscent of what happened in the fixed-income market three months earlier, when US Treasury yields fell 34 basis points before rebounding within a matter of hours (Risk December 2014). On that occasion, dealers selling options volatility to buy-side clients were caught in a ‘gamma trap', which forced them to buy into the rally, exacerbating the dislocation and leaving them unable to provide liquidity to clients for a time. In another parallel, buy-side firms that herded into the same trade – shorting US Treasuries, in this case – struggled to cover those positions as prices moved the other way.

Underpinning both stories is the reduced risk-taking capacity of dealers. Capital-constrained banks have a lower ability to warehouse risk and can no longer perform the role of ‘shock absorbers' in the market when everyone else is trying to exit at the same time (Risk August 2013).

"There is an increasing realisation that historical levels of liquidity are not being provided any more. Resource allocation by the banks is declining, whether it's risk capital or balance-sheet capacity. There is constant pressure on costs and capital, and that manifests itself in pricing and liquidity," says a European bank's New York-based head of US forex and rates trading.